Step three: Shariah view on conventional instruments

June 15, 2012 8:39 am

By Kaushiq Kodithodika, Advent

Equity-based securities – may be acceptable

Equity-based securities-shares in businesses-do not guarantee any return and in fact, the investor has a real chance of loss, so this is in line with Islamic principles. However, for a conventional equity investment to be Shariah-compliant the business must not be one that is engaged in forbidden activities, and the capital structure of the firm must conform to Islamic financial principles. These requirements are further discussed below.

Debt-based securities – unacceptable

Much of the capital markets consist of debt-based securities. Because these types of securities carry a fixed return until maturity, they are inconsistent with Islamic financial principles. Essentially, all government and corporate bonds are seen as interest-based instruments.
Instrument Classification Brief Description
Murabaha Asset or a Type of Financing Cost price (or deposit amount) plus a defined profit that may be repaid on a deferred basis. Can be used either as financing or customer time deposit.

Sukuk Communal Investment Vehicle On the “buy-side” have similar financial characteristics to conventional bonds. Often some variation of SPV owning (for the term) the asset that creates the profits. Certificates (sukuk) represent ownership in SPV.

Mudaraba Profit Sharing One partner invests funds, the other expertise. Profits are shared on an agreed basis, but not losses. Often used where an investor deposits funds with a manager (mudarib) who makes a profit from an acceptable form of investment.

Musharaka Profit Sharing Multiple partners invest funds, while a manager provides expertise. Normally, parties share profits on an agreed basis but losses are shared on a pro rata basis.

Ijara Islamic Leasing Islamic leasing arrangement. The bank acquires an asset and gives the client the right to use it in return for agreed lease payments.

Salam Agricultural Finance Buyer agrees to the advance purchase of agricultural produce to finance its planting, growing and harvesting.

Istisna’a Manufacturing Finance Buyer agrees to the advance purchase of specified goods to finance manufacture or construction.

Some primary Islamic transaction types

Preferred stocks – unacceptable

If the business goes bankrupt, preferred stockholders have priority in getting their money back over ordinary shareholders, which is unacceptable under Shariah. The provision for paying fixed dividends is also unacceptable, so these investments cannot be considered.

Derivatives – generally unacceptable

The arguments regarding the compliance of derivatives are many and complex. Financiers are attempting to create structures that may deliver the characteristics of certain derivative types. However, for the Shariah requirements of investing in real assets (not just money), the price must be certain, delivery must occur and, although there must be an element of risk and no fixed returns, there should be no speculation in the transaction. These all conspire to generally prohibit derivative-type instruments, although in some markets some emerging contract types may be deemed permissible.

Similarly for hedge funds, although financiers are trying to replicate the characteristics of hedge funds, the Shariah requirements relating to selling of assets that are not actually owned (short-selling), the requirement that income is obtained from the use of real assets and avoidance of speculation (gharar) would all act as barriers to Shariah compliance.